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David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures. Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions. Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

Miscellaneous Notes

Well, look at the DJIA and Nasdaq Composite. New 52-week highs. I am still bearish on our credit markets, tepidly bullish on equities, particularly inflation-sensitive sectors (and insurance), and bearish on Real Estate and Real Estate finance. This is a hard combo to hold together, but in some ways, I suspect that surplus capital that was making its way to the credit markets is now making its way to the equity markets.

I’m eclectic, what can I say? I’m always trying to blend signals from the long-, intermediate-, and short-term, with greater emphasis to the longer cycle elements. I’m not a trader.

Now, just a few notes to catch up on reader questions:

Why FSR and not VR or IPCR then?

I forgot about VR, and will have to consider it in the future. I like IPCR, but it has run some recently, and their aggregate maximum loss discipline will limit their returns vs those companies that use probable maximum loss.

I think your post is very useful but that it raises some critical issues about successfully forecasting future inflation/real rates. Your study period includes a period where 3 major versions of CPI existing. There is the pre-Reagan CPI, the pre-Boskin CPI and the current. John Williams at shadow statistics calculates all three. The curren pre-Reagan CPI is running over 10% so “real rates” based on that would be negative 6-7%! The pre-Boskin is I think 5-6% which would still produce negative real rates….and the Fed is cutting rates!

I wish anyone luck trying to forecast 10 year hence real rates or inflation given this mix. My personal opinion is that due to fiat currencies they are likely to be much higher unless central banks allow a deflationary credit contraction to take force without trying to inflate. History suggests that they all try to inflate!

One thing that is different about my blog is that I will do different sorts of posts. I’m hard to categorize. This comment makes some very good points, most of which I agree with. I believe inflation is understated in the US, and I think that the idea is growing in the populace, while Ph.D. economists stay in lockstep with the guild, and deny it. My main article on the topic, for those with access to RealMoney, can be found here.

Also, my main point was not to get people to try to forecast inflation and real interest rates. It was to point out how changes in inflation and real interest rates disproportionately hurt equity investors compared to bond investors. That said, it takes a large move in inflation rates to wipe out the ordinary advantage of equities.

Hi, how do you think i-bank incentive fees will effect EPS over the next year?

I worked for a technical trend following CTA in the 90’s that had a severe drawdown of -55% over the course of a year. It started with one bad day and the company was never even remotly profitable again and the owners closed it down 3 years later.

I think that people don’t understand that in order to make incentive fees the hedge funds have to make new highs, just being flat doesn’t cut it. Unless they are constantly making new highs, the hedge fund business is the same model as the mutual fund biz but with much higher overhead.

Alternatively they shut their existing funds down and open new ones to reset the mark but its hard to replace the truely large capital pools.

Interested in your thoughts.

That’s an interesting question. With respect to compensation from internal hedge funds, there will be some loss of EPS. That said, investment banks have more true technical information than most hedge funds, and will benefit from trading against funds that are in bad situations.

In general, most hedge funds that lose 25% of capital go out of business. At 50%, almost all of them do.

That’s all for the evening. Let’s see if the S&P 500 hits a new high on Tuesday.

Full disclosure: long FSR

Tickers mentioned: VR IPCR

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About David Merkel

David J. Merkel, CFA, FSA, is a leading commentator at the excellent investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited David to write for the site, and write he does — on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, and more. His specialty is looking at the interlinkages in the markets in order to understand individual markets better.
David is also presently a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. He also manages the internal profit sharing and charitable endowment monies of the firm.
Prior to joining Hovde in 2003, Merkel managed corporate bonds for Dwight Asset Management. In 1998, he joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.
His background as a life actuary has given David a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that David will deal with in this blog.
Merkel holds bachelor’s and master’s degrees from Johns Hopkins University. In his spare time, he takes care of his eight children with his wonderful wife Ruth. View all posts by David Merkel →